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Special Topic: Follow-up on the Carried Interest debate.

By Robert A. Green, CPA

We covered this hot topic on a prior conference call and on our blog. This debate is taking on feverish proportions on Wall Street, in Washington DC, in the mainstream media, and elsewhere.

Most coverage focuses on attacking the billionaire private equity and hedge-fund managers who benefit from the lower long-term capital gains tax rates (rather than paying ordinary income tax rates like almost everyone else on their working income).

There has been little coverage of potential tax and market consequences for investors.

Here is one good tax question: If the carried interest is redefined as ordinary income for managers, will that reclassification also apply to investors? In other words, will investors face higher taxes as well because they need to deduct fees rather than have reduced capital gains? Consider that most investors don’t get the full benefit of incentive-fee deductions. We considered this question on a prior conference call and on our blog.

There’s good news on this front from one of our tax attorneys, Mark Feldman JD. Investors should not face any tax changes in connection with current Senate and House bills to revise carried interest rules.

• We looked at the House bill and it seems that we need not be concerned that the amounts paid on carried interests will be non-deductible to the investors who do not exceed 2 percent of AGI limitation. The bill does not treat this as a fee paid by the partnership but as a distributive share of the partnership's capital gains and losses; on the partner level, the manager/partner treats the income as ordinary income.

• The Joint Committee on Taxation (2007 TNT 133-9) explains the bill as such:
  ”The bill generally treats net income from an investment services partnership interest as ordinary income for the performance of services. Thus, the bill recharacterizes the partner's distributive share of income from the partnership, regardless of whether such income would otherwise be treated as capital gain, dividend income, or any other type of income. Such income is taxed at ordinary income rates and is subject to self-employment tax.”
  
  
• This also seems to the intent of the House bill, as it provides:
  "(a) TREATMENT OF DISTRIBUTIVE SHARE OF PARTNERSHIP ITEMS. – For purposes of this title, in the case of an investment services partnership interest –
  
  "(1) IN GENERAL. – Notwithstanding section 702(b) –
  
  "(A) any net income with respect to such interest for any partnership taxable year shall be treated as ordinary income for the performance of services.

Just attacking managers without hurting investors may make these tax changes more palatable for Congress.

But Congress should also consider that not all carried interest receivers are billionaires; many are regular, hard-working entrepreneurs (our clients) forgoing salaries to make a share of capital gains only when their investors also make those capital gains.

I think the more limited Senate bill to repeal the carried interest on the private equity firms going public is much smarter than the more wide-scale House bill attack on all carried interest receivers.

The House bill is not addressing a key tax-theory concept, which supports the long-standing carried interest tax break.

The underlying income in focus is the allocation of capital gains to the managers. This income is capital gain in the first place, so it doesn’t make much tax sense to re-characterize it as ordinary income.

Yes, there have been many tax shelter abuses over the years; where creative accountants, tax lawyers and brokerage firms have conspired to turn ordinary income into long-term capital gains with “tax products.” These tax shelters were rightfully busted. In most, they abused basic tax theory. They did convert ordinary income into long-term capital gains or no income at all, using phantom loss techniques.

With carried interest it’s entirely different. The underlying income is capital gains and it’s usually deferred. The managers are simply in the same boat as the investors – which is what the investors want – and they are receiving the same type of income at the same tax rates. There are no shenanigans here.

Don’t confuse that with some more advanced tax schemes in the Blackstone deal, where the managers get long-term capital gains and ordinary tax-loss treatment on amortization of goodwill. That’s over the top in my view, too.

If Congress strips long-term capital gains benefits from private equity firms, these firms may have the incentive to get out of their investments even faster – in less than 12 months, the holding period required for a long-term capital gain. We should encourage longer-term investing.

Democratic presidential contender John Edwards was one of the first political heavyweights to attack the carried-interest benefit and he now seems to be using it to galvanize his wider campaign to attack the Bush tax cuts.

But how much credibility does John Edwards have on tax issues? Didn’t John Edwards avoid payroll tax on more than $50 million in legal fees by running those legal fees through an S-Corp, which is not supposed to be used by professionals? Senator Hillary Clinton won kudos for her health care initiative in the early 1990s and she is credited with the idea for the Medicare (payroll) tax of 2.9 percent applying to all earned income, not just the social security base (currently $94,200). Senator Clinton is also attacking the carried interest tax rule.

New York state senator Chuck Schumer, the protector of Wall Street, seems to be alone in trying to safeguard the carried-interest breaks. He says what’s good for the goose should also be good for the gander, so also repeal the break for oil and gas and farms – which he knows have even greater political protection in Washington.

But Schumer may feel too much political heat and have to capitulate soon. He is in charge of raising money for the Democrats to win the White House, and if this issue is the rally cry, how can he be caught in this hypocritical predicament? Is Schumer just defending his constituency and supporters with lip service to keep his stripes?

At this point, the debate is taking on French Revolution proportions, and it’s going to be hard to stop the riotous mobs. The private equity and hedge-fund managers are being painted as Aristocrats, who were tax-free. That is counter to our tax system in place from day one – graduated progressive tax rates, intended for the rich to pay more.

It’s just too easy to rally Main Street against Wall Street now. The perceptions reinforced by media de jour are that Wall Street is up to its dirty old tricks again. Buying and selling Main Street with reckless abandon, using junk bonds and big-city bank financing, to carve up assets, equity, jobs and people with little care for the long-term.

This political attack has two mutually supporting goals: Win votes on Main Street, since those voters greatly outnumber Wall Streeters; and win political campaign contributions from Wall Streeters desperate to hold off this tax change.

I have many concerns about the private-equity craze underway and some fears on how it might play out in our markets and economy. Take a look at my reply on the New York Times Deal Book on this issue, at the bottom of this article.

Why did U.S. stock markets tank the week of July 23-27? Was it because these issues are real and it’s a problem and/or because Wall Street is sending a warning shot to Congress to stand down.

U.S. Treasury Secretary Paulson is the ex-CEO of Goldman Sachs, the pre-eminent Wall Street firm with a great stake in private equity and hedge funds. Secretary Paulson has said the attack on the carried-interest tax break is a mistake because there will be collateral damage. He suggests more careful study first. Secretary Paulson also serves at the wishes of President Bush, who has defined himself as the tax cutter on investment gains – and he considers that to include carried interest (both in the oil patch and on Wall Street).

Remember the old axiom: The Japanese sell Americans Toyotas and Americans sell the Japanese U.S. T-bills, along with U.S. arms to defend shipping lanes and oil supplies. The Chinese sell Americans almost everything (Wal-Mart is their fifth-biggest trading partner) and Americans also sell the Chinese U.S. T-bills.

Does the T in T-bills stand for tribute? American power is based on freedom as an ideology, but also as a money concept with free-markets and free flows of money around the world (global trade and investing). Can Washington politicians, the seller of T-bills, really attack Wall Street, their partner in profit in selling T-bills and American stocks around the world?

Let’s ask the original great hedge funder turned philanthropist and economist and now Democratic campaign sage (founder of MoveOn.org), Mr. George Soros. I really liked his book that included his new concept on market “Reflexivity.” Perhaps, Soros learned this concept when he almost successfully shook down the Bank of England in the early 1990s by attacking the British Pound. Some argue this led to the Euro, which protects European currencies from speculator attack.

Soros realized that what matters most is putting out market fires fast with whatever it takes to prevent a wild financial fire from spreading out of control. He also realized that governments should not stand on theory, precedence or political gain, they should just put out the fire. Reflex leads to another reflex, which leads to another small change, which finally fixes things.

I wonder what George Soros has to say about the carried-interest debate now. It can be argued that the U.S. bull market is on its last legs and the U.S. is struggling with high debt loads and bad press around the world. In can also be argued the Asian tigers can jump ship on their T-bills for product exchanges anytime soon. Is it wise to have a French Revolution on Wall Street now?

In my view, a strong argument can be made for taxing gains earned by deal-makers (in private equity, hedge funds, real estate, oil and gas) as ordinary income.

The Bush tax cuts did create an even bigger gulf between ordinary income tax rates and long-term capital gains (20 percent), which caused (over-the-top) tax professionals and private “wealth managers” (the deceiving Wall Street title) to become tax alchemists, turning higher tax rates into lower ones.

My beef is politicizing this issue now and garnering a mob mentality, with little regard for the true underlying tax concepts and potential collateral tax and market damage.

Look at the Sarbanes-Oxley (SOX) experience. The debate at that time was how to fry the Enron, WorldCom and other corporate abusers and prevent that type of corporate fraud from every happening again. SOX socked it to U.S. corporations and it’s been an employment act for accountants and attorneys, which contributed to the private equity bonanza.

Young and/or distressed mature companies couldn’t afford SOX compliance costs and oversight, so some succumbed to the private equity wolves. Private equity firms repackaged these companies into a fund-of-fund private equity firm, which itself later went public with reduced SOX compliance costs and oversight. This is a classic case of over-regulation and fiscal policy having unintended and equally bad outcomes.

It’s a funny thing about regulation and high taxes. They push activity to lower-regulated areas and lower taxes. Look at my article in Active Trader a few years back on hedge funds. I argued that hedge funds were the least regulated financial service firms and financial impropriety would seek them out. Private equity firms are just like hedge funds in this regard, and they even help each other in their pursuit of profit. http://www.greencompany.com/HedgeFunds/ActiveTraderGreenHedgeFundsJan2006.pdf. Hedge funds assemble voting blocks and then vote for private equity firm takeovers.

Great fortunes with great impropriety built America, and they also built Britain, France, and now China and Russia. Attack the fortune makers and they will find friendlier jurisdictions and new ways to practice their craft. These days, it’s easier than ever for money to flow offshore and then back again in the guise of offshore funds. Let’s be smart about these changes and not have carnage and blood in our Wall Streets.

Media attackers of the carried-interest and private-equity players base their argument on the perceived fact that private equity firms are not risking much money (or really anything at all) and therefore don’t deserve capital gains treatment (or any special treatment at all). Others argue that managers are just collecting income from their services, no different from those who earn a salary.

These perceptions are flawed. Private-equity firms are risking their hides, just like the Enron and WorldCom managers. If they rape and pillage an underlying company, or don’t perform as they represented, or their deals just blow up, they can be sued for tremendous sums and even face jail time. In my book, that counts as plenty of risk capital. Certainly more than most who collect ordinary income in other jobs and professions. Yes, doctors, lawyers and accountants have risks, but they also have professional liability insurance, and it's not on the same scale of risk, in my view.

Which one of the media pundits is ready to quit their job, form their own media property or blog, forgo a salary and try their hand at the capitalist dream?

Robert Green’s entry on the NY Times Deal Book blog on June 8, 2007, in reply to an article on the excesses of private equity:

Deja Vu. In the go-go late 80s, Drexel’s junk bond LBO craze crashed and burned when a recession coupled with higher interest rates crashed the brilliant young MBA’s worksheets (forecasting profits). These worksheets were the entire basis of many M&A deals (not real-world reality). Declining company profits could not cover rising interest payments and many deals were unwound.

No problem for Wall Street. They advised the underlying companies on the original deal and were paid to restructure the deals for banks, many of whom were bailed out by taxpayers in the simultaneous real estate crash. Wall Street eventually took many of these companies public again in the returning go-go 90s.

The current spin on this same old story may have started with over-reaching SOX, intended to put out Enron “off-balance-sheet” type fires. It’s sadly ironic because this has led to a rush to be private to avoid SOX and go even more off balance sheet. Just imagine the schemes and deal-making that private equity firms can cook up with their Wall Street and banking brethren, outside of the public’s view, with little reporting to private equity investors and not enough real business players at the table. Enron shareholders could sell, but private equity firm investors rarely can with lockups.

Here’s the big problem and question: Do you really think the private equity firms can run these target companies better than the existing management and ownership? I seriously doubt it. Private equity firms’ management is being stretched very thin with the rash of deals and their managers are trained as traders and deal-makers, not operating company managers. It’s easy to insult management, but much harder to make a product that customers want to buy in a profitable way for the company over the long-term. Plus, private equity firms add on layers of fees and are accustomed to manipulating companies as suits them best.

Don’t worry just for the investors, worry for the workers in these target companies. It’s Enron all over again, with disappearing jobs and pensions and wrecking of long-standing established companies.

Yes, lots of existing management sticks around, but the entire chemistry is off and existing management is not given enough say.

I view these private equity funds as becoming similar to a class of Funds of Funds, as they exist in the hedge fund space. Again, there are probably lots of added fees and conflicts of interest draining the underlying target companies.

Funds-of-Funds hedge funds and private equity firms are competing to rush to market themselves as the next high priced IPO. They are rushing together portfolios, and their MBAs are crunching worksheet numbers to dwarf the Drexel junk bond guys.

All industry players have a stake in building this house of cards. It’s all transaction canon fodder for NYC’s financial power machine, made up of private equity, Wall Street, banks, big accounting and law firms, and their supportive institutional and wealthy private investors.

As you stated, this craze is putting pressure on other public companies to initiate and continue major share buybacks.

This has the effect of reducing the available stock to buy publicly, which is classic financial inflation – more demand and less supply.

SOX has not cleaned up the playing field or reigned in the players, it’s only moved the game into a new arena – private equity and hedge funds.

In my attached article for Active Trader, I pointed out how financial impropriety moves to the least-regulated entities like hedge funds.

To date, everyone is winning this game including hedge-fund investors (sellers), the private equity buyout companies (buyers), the banks (enablers), the service firms (selling the gold picks and shovels) and even online traders (based on hype with volatility).

But these types of cooperative power plays based on hype usually end badly for many investors.

If things turn bad – as you point out from rising interest rates – how will investors in private equity funds and hedge funds sell their interests? The answer is they are locked in usually and they won’t be able to sell. How convenient is that for the power players? SOX and liquid securities protect investors, but few investors are protected in hedge funds and private equity funds.

Plus you rightly pointed out that bond investors in these deals may rush to sell and drive up interest rates even further.

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